Most employees have a contract of employment setting out the basic terms, conditions, expectations and requirements. That allows things to be straightforward, but companies and individuals, nevertheless, make all kinds of attempts to avoid the obligations and liabilities that should be part of the standard employment relationship.
For instance, the parties may agree to create a service contract between two business entities. While the structure of this contract may well be perfectly valid, in that one company does indeed provide specified services for the other, the intention is to disguise the underlying relationship, which is in effect a contract of employment. Typically, what alerts the authorities is that the supposed service company has one member of staff and only one customer, making the two parties in effect employee and boss.
There are various reasons for setting up this kind of service contract. In the case of employers, it is usually because they hope to evade their legal and statutory obligations to staff, such as providing paid annual leave, severance payments, long-service payments and MPF contributions. They may also believe that engaging individuals in the guise of independent contractors gives them a stronger bargaining position and makes for greater workforce flexibility. As for the service providers, or employees, the aim of this arrangement is generally to reduce taxes. By receiving income via a company they control, it may be possible to claim deductions for expenses chargeable against tax and to take advantage of more generous allowances relating to profits tax on fees received as opposed to salaries tax on personal income.
Down the years, though, the Inland Revenue Department (IRD) has taken proactive measures to crack down on these disguised employment arrangements.
So, if Hong Kong taxpayers operate as an independent contractor or service company, they may find themselves subject to investigation under specific anti-avoidance provisions set out in various sections of the Inland Revenue Ordinance (IRO). Where these provisions apply, the IRD may look beyond the superficial arrangement, and this can lead to holding the de facto employee liable for salaries tax and penalties.
The maximum penalty is a fine of HK$50,000 plus three times the amount of tax undercharged or evaded, plus the tax due and possible imprisonment of up to three years. If there has been any non-assessment or under-assessment due to fraud or wilful evasion, the IRD may take action within 10 years after the end of the year under review. Taxpayers can make an appeal to the board of review and to the appellate courts.
An "employer company" which wilfully and with intent assists the evasion of tax is liable to penalties comparable to those for the individual taxpayer.
It is common knowledge that de facto employees hiding behind a service company do not report any income chargeable to salaries tax. However, "consultancy fees" or similar received by their company will be chargeable to profits tax - after deducting a variety of expenses - for "carrying on a trade, profession or business in Hong Kong" under Section 14 of the IRO. And Section 9A imposes a prima facie liability for salaries tax if remuneration is paid to a company controlled by the individual rendering those services, or by a relative or partner.
The objective of these anti-avoidance provisions is to defeat arrangements that are artificial, fictitious or entered into solely or mainly to obtain a tax benefit.
The 2002 Court of Appeal case of Cheung Wah-keung versus Commissioner of Inland Revenue concerned a typical scenario whereby the remuneration paid to the de facto employee was funnelled through an entity controlled by him. The court upheld the view that the arrangement had no commercial reality, that it was artificial and should be disregarded.
The decision also demonstrated that the IRD and the courts are prepared to invoke provisions to deem fees received by a service company to be salary income of the individual. If one is still considering the option of operating through a service company, workers should also be mindful of the costs.
There will be business registration costs and recurrent expenditure for legal and accountancy fees. An equally important factor is the loss of protection afforded by statutory rights and benefits guaranteed to employed persons under legislation, such as the Employment Ordinance and the Mandatory Provident Fund Schemes Ordinance.
Should the "employer company" become insolvent, there could also be problems for a service company to get outstanding monies paid. In such cases, an employee would have priority to receive wages and termination benefits, according to the provisions in the Companies Ordinance, which also makes direct employers liable to cover occupational injuries that occur in the workplace.
Individuals should carefully balance the tax advantages gained against the rights and benefits lost as an employee before accepting or proposing a disguised employment arrangement. If in doubt, it is possible to obtain an advance ruling on tax affairs under Section 88A and Schedule 10 of the IRO.
Jenny Lee is senior attorney and Christopher Ma and Ivan Lai are trainee solicitors of Jones Day
